FMPs crisis: Lessons for all to learn

'Why are FMPs used as a vehicle for promoter funding against listed shares?' asks Debashis Basu.
Illustration: Uttam Ghosh/Rediff.com

Investors in mutual funds have woken up to another rude shock.

A few months ago it was some debt funds that were found to have a massive exposure to the nearly bankrupt Anil Ambani group, the overstretched Zee group, the controversial Dewan Housing and the tottering, mismanaged giant Infrastructure Leasing & Financial Services.

This festering issue has hit the fund industry again.

This time it is fixed-maturity plans (FMPs) that have an exposure to the Zee group.

A few FMPs of two fund houses that were maturing have either not been able to pay their investors in full, or have extended the maturity date, because they have an 'exposure' to the Zee group and the group is not able to pay back.

The fund houses have tried to explain away the issue, but they can't disregard that the word 'fixed' in FMPs denote that the money will be fully returned to the investors after a fixed period.

Not being able to pay back fully, or extending the duration, is a serious breach of terms, a serious breakdown in the system.

What are the lessons from this? It is that the regulator, the fund houses and investors should go back to the first principles.

Lessons for mutual funds

Funds have come up with various convenient explanations, including that they are acting in investors' best interests (after having been reckless in their investment decisions in the first place); but, the fact remains they have lent money against Zee group shares but cannot sell those shares because too many of 'lenders' are in the same predicament.

If they try to exit, as they should, in the event of a default, prices would crash by 30% or more.

Now, any perceptive observer may ask: Since investors in FMPs have invested in debt securities, what do they have to do with Zee shares? If they wanted an exposure to Zee shares they would have bought equity funds or the shares directly.

This is the elephant in the room that no one wants to talk about.

What mutual funds have done in most of these cases is called 'promoter funding' against listed shares.

In my book, promoter funding does not amount to investing in debt securities.

And, it is most certainly a disastrous strategy for a fixed-maturity plan to be lending money against a volatile collateral such as listed shares.

This gets further compounded when 40 entities -- from mutual funds to finance companies -- lend against the same shares like a herd.

The herd is trapped.

They cannot sell.

Mutual funds, investing public money, have no business lending against shares because it violates the principle of not taking a bet on equity-like high risk in debt products, which offer limited returns.

That leads us to our next lesson.

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Lessons for investors

At Moneylife, for more than 10 years now, we have consistently said that savers and investors should avoid FMPs.

The principle is simple.

Equities are risky, but they offer higher expected returns.

Debt products are less risky and offer lower returns.

This is why when it comes to equities, investors should be risk takers, while when it comes to debt, they should be risk-averse.

Alas, investors do the opposite.

They are risk-averse with equities (too little allocation) and risk-takers with debt -- falling for just that extra bit of interest and tax saving.

The second aspect of debt products is that the nature of risk varies from one category to another.

If you have made a deposit in a good company or a scheduled bank, you have a low risk.

Both the interest rate and duration of investment are fixed and you get back the interest and principal.

But debt funds are a different kind of product.

They don't pay interest.

The funds (and you) are taking a debt market exposure and so you get capital gains (and losses).

Now, this is a different kind of risk -- the risk of timing incorrectly -- in what is mistakenly called a fixed-income product.

Do you have the expertise to time the debt market? You don't.

It is a risk worth avoiding.

Or, go for a product that completely minimises timing risk --such as liquid funds and short-term funds.

And, of course, we now know that debt funds can inflict an equity market exposure through loans against shares!

Lessons for Sebi

The above lessons, based on first principles, are not new for investors and funds.

But they tend to forget them due to behaviourial biases -- short memory, greed, herd instinct, and so on.

The regulator, a dispassionate referee, should have no such biases.

Plus, it should have an institutional memory to help it do the right thing.

Fortunately, the Securities & Exchange Board of India under the current chairman, Ajay Tyagi, has taken several steps to clean up the mutual fund business, which had launched too many products in too many categories, many of them useless.

Unfortunately, Sebi seems paralysed when it comes to the failings of debt funds and FMPs.

Sebi needs to ask why FMPs are used as a vehicle for promoter funding against listed shares.

Doesn't it involve equity risk? If so, why is this a product in any debt mutual fund? Sebi also does not seem to have cracked down on MFs funding promoters' investment vehicles (YES Bank and Dewan Housing).

The worst of all, of course, is the terrible job credit-rating agencies seem to have done in rating many debt securities, including assigning top rating to IL&FS debt.

All these violate the first principles.

It is time to get back to them.

And while they are at it, Sebi officials may like to go back to the great FMP scam of 2008, which seems to be lost from its institutional memory, too.

Debashis Basu is the editor of moneylife.in